Save Yourself From the Bond Bear

The possibility of losses in bonds has some people running scared, but you should stay smart.

Investors look to bonds as a way to protect their portfolios from the risk of the stock market. But for some time, many professional investors have seemed more concerned about risk in the bond market than the potential for a stock market reversal, and some of their advice runs against established asset allocation principles that investors have used for decades to plan their portfolios.

Why bonds are importantIf you've ever set up an investing plan for long-term goals like retirement, you're used to seeing bonds play an important role in achieving those goals. Typically, a portfolio for a financial goal that's still well in the future tends to be stock-heavy, with relatively little exposure to bonds and other fixed-income investments. As the goal approaches, however, allocations to bonds usually increase, giving up the appreciation potential of stocks for the reduced volatility and greater certainty of payout that bonds provide.

The combination of extremely low interest rates and trouble in certain areas of the bond market has led several financial advisors to trim bond allocation recommendations for their clients. In particular, BNY Mellon and Barclays have cut bond allocations by a quarter to a third. Some independent advisors have even eliminated bonds entirely from their client portfolios. With stocks at multiyear highs, is cutting back on bonds now an example of the worst possible timing?

Making the move away from bondsThe idea of moving conservative investors away from their long-held bond allocations may seem completely counterintuitive. After all, in theory, bonds are less risky than stocks. When you look at the hierarchy of a company's capital structure, bondholders have a higher rung on the ladder than stock investors. If a company goes bankrupt, shareholders have a high probability of losing everything. But often, bondholders will get a significant portion of their investment back. For instance, after General Motors(NYSE: GM) filed for bankruptcy in 2009, old bondholders eventually ended up with a claim to shares and warrants in the new company, while old shareholders got nothing.

But bonds are definitely not free of all kinds of risk. Even Treasury bonds, which many consider completely free of default risk since they're backed by the full faith and credit of the U.S. government, can fall in value substantially when interest rates rise. That's a big part of why the Vanguard Extended Duration Treasury ETF(NYSE: EDV) has dropped more than 25% since last August, with Vanguard Long-Term Treasury(Nasdaq: VGLT) not far behind, down 15% from its 52-week high.

Better alternativesOne reason why buying bonds makes little sense right now is that the reward you get from owning bonds doesn't justify the risk. Consider: The iShares Barclays 3-7 Year Treasury ETF(NYSE: IEI) has a Security and Exchange Commission-defined yield below 2%. But that's less than the average rate on five-year bank CDs that carry the guarantee of the Federal Deposit Insurance Corp. And with some institutions paying as much as 2.75%, buying an ETF that can lose value if the market moves against you makes no sense at all. Similarly, high-quality corporate bonds carry somewhat higher rates, but even the iShares iBoxx Investment-Grade Corporate ETF(NYSE: LQD) yields only 4.33% despite having an average maturity of nearly 12 years.

On the other hand, some parts of the bond market have fallen far enough that their potential future returns may be giving you enough reward to justify investing. Municipal bonds, for instance, have dropped recently as many have expressed fears about whether state and local governments will be able to meet their obligations. But with many muni bonds paying higher rates than comparable bonds despite their paying tax-free interest, tax-averse investors are paying greater attention to the space. The aptly tickered PIMCO Intermediate Muni Bond Strategy ETF(NYSE: MUNI) is one place to look for broad-based exposure to munis.

To eliminate interest rate risk entirely, one reasonable solution may be simply to use high-yield savings accounts. Short-term Treasuries pay next to nothing -- SPDR Barclays 1-3 Month Treasury ETF(NYSE: BIL) has a yield of 0.04%. But at certain banks, you can find rates of 1% or more -- not a huge amount, but more than two-year Treasuries will pay, and without the penalty of locking up your money.

Make the smart moveIn the long run, you don't want to give up on bonds forever. But with bonds potentially poised to fall, assessing and adjusting for your risk makes sense. Making moves to protect yourself makes sense if you're exposed to greater risk than you can handle.

Author

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.
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